How to profit from uncertainty

Around a decade ago, a 43-year old investor of Indian origin was determined to make it happen.

Buffett holds an annual charity lunch auction. The winner and up to seven friends can dine with him and the proceeds go to charity. The 43-year old decided to blow everyone out of the water with his bid. (He had been outbid in four previous instances.) In 2007, he, along with a friend, put up $650,100 and were selected as the highest bidders.

Say hello to Mohnish Pabrai of Pabrai Investment Funds. Pabrai’s investment style is heavily influenced by Buffett's investing philosophy and he refers to himself as a "humble disciple" and "shameless cloner" of the Oracle. Instead of chasing diversification, Pabrai believes in being selective (few bets, big bets, infrequent bets). His investing is largely moat based. He also looks at the intrinsic value of the company to ensure that he is buying at a great price. Little wonder that he wanted to break bread with Buffett.

In a Forbes post titled How Mohnish Pabrai crushed the market by 1100% since 2000, the writer points out that Pabrai has nerves of steel and invests with unshakable conviction. He reaches out and grabs a stock falling like a dagger and then keeps buying while it plummets into the abyss.

I remember seeing him in September 2008 when his fund was down 60% and the global financial system was coming off the rails. These facts bounced off him like a pea-shooter. His only concern was finding cash to buy stocks while they were still cheap.

This behaviour ties in with his idea of “low risk, high uncertainty” investing.

Pabrai claims it is something he learnt from entrepreneurs. People are under the misconception that entrepreneurs take risks and get rewarded for it. In reality, entrepreneurs do everything they can to minimize risk. They are not interested in taking risk and go after free lunches. They focus on low-risk bets which have high-return possibilities. Not high risk-high return. But low risk-high return.

He cites the example of Bill Gates in this context. The capital he put in was meagre. It was high uncertainty (Gates could have gone bankrupt) but not high risk (no capital deployed). Gates was comfortable with uncertainty but did not take any risk.

In his book The Dandho Investor, Pabrai says that low risk and high uncertainty are a wonderful combination. Risk is the potential for capital loss, while uncertainty is a wide range of possible outcomes. When The Street gets confused between risk and uncertainty, it is time to profit handsomely from that confusion.

How Pabrai made money on uncertainty – Stewart Enterprises

In the fall of 2000, Pabrai noticed two stocks that kept standing out, week after week, with lowest P/E ratios: Service Corp. and Stewart Enterprises. Both were in the funeral services business.

Following a debt-fueled consolidation of the funeral-home business, companies like Stewart Enterprises, Loewen and Service Corp. ended up highly over leveraged. After Loewen couldn’t handle its crushing debt load and went bankrupt, investors lost their excitement for the funeral business, and the stocks started to plummet.

According to Pabrai, funeral homes must trade at double-digit P/E ratios because the cash flow has a very high degree of certainty. Here’s why:
•Families want the last rites of their loved ones to be done right. They don’t go shopping for the low bid. They are likely to follow tradition and use the services of the same funeral home that the family has used in the past.
•The morbid nature of the business provides for high entry barriers.
•It was not an industry with rapid change (industries with rapid change are bad for investors).
•The population continues to grow leading to an increasing revenue stream.
•Pre-need sales make up for 25% of the total revenue for many operators (they pay for the service now which will be delivered probably decades later).

What the financials of the company revealed:
•$930 million of long-term debt with about $500 million due in 2002
•$700 million in annual revenues
•Ownership of 700 cemeteries and funeral homes in 9 countries, with the bulk of them in the U.S.
•Tangible book value was $4 per share. The stock price of Stewart Enterprises dipped from $28 to under $2 per share in two years. It was thus trading at half of book value. Since book value included hard assets like land at cost, it was likely understated.
•On an annualized basis, it was producing free cash flow of about $0.72 per share. The stock was trading at less than three times cash flow and about one-quarter of annual revenue.

Pabrai arrived at five possible scenarios for Stewart Enterprise over the next 24 months and looked at the odds of each scenario playing out.

There was much uncertainty how it would play out but the risk of permanent capital loss was under 1%.

Pabrai Funds invested 10% of its assets into Stewart Enterprises at under $2 per share in the third and fourth quarters of 2000 with a target sell price of $4.

The company begun to explore the sale of international funeral homes and cemeteries since international assets weren’t generating much cash flow. As a result, the company was attempting to eliminate the debt without any reduction in their cash flow. In the first half of 2001, the stock price went over $4 per share and Pabrai exited.

How Pabrai made money on uncertainty - Frontline

In 2001, Pabrai was looking at a list of companies that had high dividend yields. Since a high dividend yield is sometimes indicative of a stock being undervalued, Pabrai found it a worthwhile screen.

Two stood out with dividend yields over 15%. Both were in the crude oil shipping business. Since he wanted to understand why they had such a high dividend yield, he spent a month studying the businesses of Knightsbridge and Frontline – both had completely different business models.

Knightsbridge’s tankers were given on a long-term lease to Shell Oil. Shell would pay them a base lease rate (say $10,000 a day per tanker) regardless of whether they used them or not. And, a percentage of the delta between a base rate and the spot price for tanker rentals.

For example, if the spot price went to $30,000/day, they might collect $20,000 a day. If the spot was $50,000/day, they’d collect, say, $35,000/day. The way Knightsbridge was set up, at $10,000 a day; they were able to cover their principal and interest payments and had a small positive cash flow. As the rates went above $10,000, there was a larger positive cash flow, meaning more excess cash for shareholders.

When tanker rates go up dramatically, this company’s dividends goes through the roof. This happened in 2001 when tanker rates went to $80,000/ day and the dividend yield went through the roof. But because it was not durable or sustainable, the stock didn’t jump up significantly.

At that time Frontline had the largest oil tanker fleet in the world, amongst all the public companies.

Since the entire fleet was on the spot market with very few long-term leases, there was no such thing as earnings forecasts or guidance. The company’s CEO himself did not know what the income would be quarter to quarter since earning widely gyrated.

Oil tanker rates varied from $6,000 to 80,000/ day. The company needed about $18,000/day to break even. If rates go below, they bleed red ink; if rates go above, they make huge profits.

When Pabrai was looking at it, oil tanker rates had collapsed to $6,000/day. The stock appropriately slipped from $11 to about $3 in about 3 months.

While the rates had collapsed for daily rentals, the price per ship hadn’t changed much, dropping about 10-15%, nowhere near the price magnitude of the drop in the share price.

The company had around 60-70 ships with a liquidation book value of about $16.50 per share, which meant that if they simply shut down the business and sell the ships, shareholders would get about $16 a share. At the collapsed ship price, it would still be $11 per share. If one could buy the entire business for $3/share, one could turn around the next day and sell the ships and clean up.

Also, the company was cash rich. They could handle $6000/day rates for several months without a liquidity crunch. The total annual interest payments were $150 million. Even if income dropped to zero, they could sell a few ships per year at $60-70 million per ship and keep the company going.

After the Exxon Valdez spill, all sorts of maritime regulations were instituted requiring all new tankers to be double hull because they are less likely to spill oil. The entire Frontline fleet was double hull tankers.

It takes four years to build a new tanker, so when demand comes back up again, inventory is very tight. There is a definitive cycle. When rates go as low as $6,000 and stay there for a few weeks, the rise to astronomically high levels is very fast. With Frontline, for about seven or eight weeks, the rates stayed at under $10,000 a day and then spiked to $80,000/day.

In the second half of 2002, Pabrai started buying the stock around $5.90.

Once he began approaching $10, he started to unload of the shares. Though it happened over a very short period of time, Pabrai Funds had a 55% return on the Frontline investment and an annualized rate of return of 273%.

While there was real uncertainty over exactly when and how the story would play out, Pabrai saw the risk of a permanent loss as extremely low.

When asked about it, he explained that for a few months the market offered him an ultra low-risk but ultra high-return opportunity to invest in this business. There was virtually no downside, but tremendous upside. A classic “Heads, I win; tails, I don’t lose much” type bet. Except that the odds of getting heads was way over 50% percent, and if it came up tails, it simply meant that he either broke even or made a little money.